As a reminder, the tax code requires that retirement account owners begin taking distributions out of their pre-tax retirement accounts when they reach a certain age.  Through calendar year 2019 the triggering age was 70.5.  For all those who were not 70.5 years old by the end of 2019 the new triggering age is 72 thanks to the SECURE Act of 2019.  If your retirement account is a 401(k) and you are still working at the sponsoring company then RMDs are deferred until the year of your retirement for non-owners that would otherwise be required to take the RMD.  Those that have inherited a retirement account prior to 2020 are also generally required to take RMDs.

But what about those savers that had already taken their 2020 RMD by the time the CARES Act was passed and do not need the money?  The good news is that the IRS recently provided relief for those situations.  Anyone that took an RMD in 2020 now has until August 31, 2020 to re-deposit the full amount into their retirement account.  These re-deposits will be considered a rollover but will not be subject to the typical 60-day requirement and will not be subject to the typical limit of one such indirect rollover allowed per year.  Therefore, you can do this for as many RMDs as you took in 2020.  This option will also be open to the owners of inherited accounts, which typically are prohibited from this type of transaction. In short, anyone is now eligible to reverse their RMDs taken in 2020 for the extended period.

This is great news for those that would have preferred not to take an RMD but already had.  Others may still want to take their RMD for 2020 to cover expenses or to take advantage of a potentially lower tax bracket if their incomes have been impacted by the COVID-19 crisis.  Every situation is different so you should consult your CCP advisor and your tax advisor to help determine the best course of action for you.

Please do not hesitate to reach out with any specific questions you might have.

One such example is the desire to suspend contributions to retirement savings during down markets. The logic is simple; investors have seen their invested capital fall in value so they are hesitant to add more capital that may also fall in value. It forgets, however, that the price of the investments that your savings plan requires you to accumulate over time have fallen along with your account value. That means that you’re able to purchase more shares per dollar of contribution during periods of down markets.

The net effect is that by continuing to make your planned contributions you accumulate extra shares. Those extra shares not only mean better long term performance, but it also allows you to get back to break even faster once markets begin to recover.

Let’s look at an example using the Great Recession S&P 500 Bear Market of 2007 through 2013:

In this scenario, we’re assuming that two investors each had $100,000 invested in the S&P 500, an admittedly non-diversified portfolio but one that easily illustrates the point. Portfolio A, represented by the red lines, shows a portfolio invested entirely in the S&P 500 with suspended contributions. The pale Red line is the invested principal, which doesn’t change because no new contributions are being made, while the dark red line is the portfolio value. Portfolio B, represented by the blue lines, shows the portfolio where the investor continued making monthly contributions. As with the red lines, the light blue line represents the invested principal. In this case it rises steadily over time because of the recurring contributions. The dark blue line represents the actual fair market value of the initial holdings plus the value of all invested contributions.

As you can see, the investor who stayed true to their savings plan and maintained their contributions, portfolio B, saw their portfolio value surpass their invested principal a full year faster than that of the investor that suspended their savings plan, portfolio A. Further, the fair market value of portfolio B ended the example period roughly $30,600 larger than the invested principal, while portfolio A ended with roughly $5,700 more than the invested principal. Faster break-even, better long-term return.

While the desire to take action to make ourselves feel better during down markets is understandable, the common method for doing so, stopping contributions, often ends up preventing us from recouping losses more quickly. While it may seem counter-intuitive, sticking to your savings plan, or increasing it, can help provide the desired results.

In short, the Act allows for impacted individuals to withdraw up to $100,000 from their retirement accounts in 2020 without the 10% early distribution penalty, for those under age 59.5, and allows the income tax obligations created by the distribution to be split over 3 tax years. It also allows you to pay back the distribution at any time within those 3 years, in effect making the distribution an interest free loan. Further, the limit on the amount that can be borrowed from a 401(k) have been doubled.

These rule changes will certainly act as a much needed lifeline for many Americans in desperate need. For those that are not in dire need for short term funding, however, taking advantage of the ability to access retirement funds without penalty can be expected to have tremendous negative effects on a retirement savings plan. It would amount to shifting a race car into reverse during a race.

To illustrate this, our friends at JP Morgan Asset Management created a simulation to show the effect of taking loans on a 401(k).

As you can see, taking 2 loans and one distribution (each for $10,000) over the 40 year period resulted in an ending balance that was 26% smaller by retirement, or about $350,000 in this illustration, despite the fact that two of the three were fully paid back. The result would be far more pronounced as the size of the distribution/loan goes up, and if distributions are taken rather than loans that are paid back. This scenario is also assuming a moderate, 60/40 investment strategy. The difference would be even more striking in an environment with higher portfolio returns over the period, such as would be expected with a more growth oriented portfolio or if loans were taken during market downturns before markets were able to recover.

The damage done is from missed market participation while those dollars are out of the market. This is especially true when loans/distributions are taken during times of market weakness, like today, since the assets taken out of the market at distressed prices are not there to participate in the rebound. As the chart below shows, rebounds from bear markets have historically been powerful and fast.

In summary, while these new provisions will act as a much-needed lifeline for those impacted by COVID-19 that are struggling to stay afloat, they will act as an anchor for those that use them unnecessarily. If your goal is to win a race, the first step is to drive forward rather than backward.

How much cash is too much cash?

While holding cash gives the perception of safety and security, it has also generally given one of the lowest long-term returns.  It is important to remember that while volatility risk, or the risk that your principal may be lost, is near zero with cash it is not the only risk that applies.  Inflation routinely eats away between 2-3% of the value of your dollars each year, on average.  In other words, the value of a dollar is measured by the goods and services that you can trade it for.  As the price of those goods and services rise, your dollar buys less.  Another way to say that is that your dollar has lost value, even though it is still in your hand (your principal is intact).  With interest rates now at historically low levels, the gap between the interest your cash earns and the expected rate of inflation is wide, meaning the inflation penalty on your cash balances the largest since the Great Recession. Therefore, it is possible to hold too much cash from a defensive perspective, as well from an opportunistic perspective.

Savings can be thought of as three basic categories: emergency funds, short term goals, and long term goals.  Given the short-term nature of an emergency fund and short term goals, defined as planned major expenses coming within the next 1-2 years, these should be funded with cash.  The short time frame limits the damage done from inflation and is too short to take on the volatility risk associated with financial markets.  A proper emergency fund should contain somewhere between 3 and 6 months worth of your non-discretionary expenses.  If your emergency fund is adequately funded and you have cash set aside for known major expenses coming in the near future, then any cash beyond that level could be considered excess and should be considered for your longer term goals, like retirement.  If these categories aren’t fully funded, then your focus should be on building those cash balances before shifting your focus to your longer-term goals.

Excess cash

Assuming that you are already on track with your target savings rates for your longer-term goals, as determined through your accumulation plan, and that your necessary cash levels are satisfied, the next decision is how best to make use of your excess cash.  In its simplest form, this decision boils down to paying down debt or adding to investment portfolios.  While it’s rarely a bad idea to pay down debt, the dramatic move lower in interest rates has provided an opportunity for the refinancing of debt at very low levels, thereby achieving the goal of reducing your overall interest expense without dedicating significant capital.  The lower the interest rate level, the less attractive it is to pay that debt down more aggressively.  At the same time, heavily discounted markets provide the opportunity for attractive intermediate and long term returns in excess of the savings to be had by paying down low rate debt.  In the end, the decision to pay down debt or increase your savings rates will need to be made on a case by case basis with the help of your trusted advisor.

Is now the time to get in the market?

There’s no question that the speed and scope of this bear market has been unnerving for investors.  While most people intuitively understand that you want to buy when prices are low, the reality is that it’s much harder to follow through when faced with a market like this.  Market bottoms are rarely a comfortable time.  Rather, markets usually bottom when we feel the worst, making it all the harder to accurately time them. With this in mind, the question for investors is whether it’s better to be early, and potentially feel some initial downside, or be late and miss some of the initial bounce.

As the chart above shows, it has historically been more profitable to be slightly early when putting cash to work. Yet, investors with cash to invest often want to wait for markets to settle down, meaning they wait until they feel better about things.  Given the speed with which markets move in these types of environments, this strategy often leads to investors getting in after the market has bottomed.

The right decision

As with much of personal finance, it’s impossible to accurately and repeatedly time markets in any environment, let alone during periods of immense volatility as we’ve seen during the COVID-19 bear market.  That being said, all bear markets end at some point and transition into a recovery.  While it may be an uncomfortable prospect to put more of your assets at risk, history has shown us that times like these eventually reveal themselves as buying opportunities once we have the power of hindsight.  Now is the time to work with your trusted advisor to determine a cash management strategy that is appropriate for you and your goals.

So now that we’re on the other side of the shut down, how did this one play out?

As you can see, the S&P 500 was up over 13% over the course of the shutdown, making it the best shut down we’ve ever had (from a performance perspective that is). Granted, this chart shows correlation but certainly not causation. There were many factors driving markets during the shut down and I’m not trying to suggest that the shut down drove the market up. Quite the opposite in fact. The purpose of my original post was to remind readers that despite their headline grabbing nature, they really don’t mean much for the economy or the markets over the long term (remember this was the THIRD shut down of 2018).

In fact, the Congressional Budget Office (CBO), a non-partisan government agency created to provide Congress with independent analysis of economic and budget related legislation, just today announced their estimates of the economic cost of the shut down. The full article can be found here. They estimate that about $11 Billion worth of economic activity was lost during the shut down. Delayed contracts, purchases, licenses, and paychecks are just some examples of things that didn’t happen while the government was closed. However, they also estimate that about $8 Billion of that lost activity would be recouped eventually (think back pay, buying stuff they planned to earlier and the like). This means that only about $3 Billion would actually be lost. To put that in perspective, the US Economy is estimated to have produced roughly $20 Trillion of activity in 2018 (we don’t have final numbers yet because of the shut down, of course). $3 Billion is 0.015% of the US economic output. It’s a rounding error.

The real impact of a shut down is on the families of Federal employees, and in the damage done to consumer and business confidence. Time will tell how much that damage will impact the economy or the markets, if at all. Sadly, the agreement only funds the government until February 15th. If Congress can’t come to a border security deal by then we may be facing yet another shut down. If you’re a Federal employee it might be a good time to work on your emergency fund. For everyone else, the good news is that shut downs haven’t seemed to matter, historically. Is there an echo in here?

Austan Goolsbee - The Robert P. Gwinn Professor of Economics at Booth. Dr. Goolsbee served as the Chairman of the Council of Economic Advisers for President Obama and was a member of his cabinet. He’s also a member of the Economic Advisory Panel to the Federal Reserve Bank of New York, and a frequent guest contributor on business television.

Randall Kroszner - The Deputy Dean for the Executive Programs and the Norman R. Bobins Professor of Economics at Booth. Dr. Kroszner served as a Governor of the Federal Reserve System from 2006 until 2009, and was instrumental in the Fed’s response to the 2008 Financial Crisis. He also worked in the Bush administration as a member of the President’s Council of Economic Advisers. He, too, is a frequent guest contributor on business television.

Raghuram Rajan - The Katherine Dusak Miller Distinguished Service Professor of Finance at Booth. Dr. Rajan was the 23rd Governor of the Reserve Bank of India, and has served as the Chief Economist and Director of Research at the International Monetary Fund.

These short lists of accomplishments don’t even begin to cover the achievements of these men. Take a moment to learn more about their backgrounds by clicking on the links in their names.

My main takeaway from the event was how diverse the opinions of these three giants of economics were. Despite working at the same highly prestigious University, studying many of the same topics, each had a different opinion on nearly every topic addressed compared to the others. In the instances where consensus was reached, their reasoning behind that consensus opinion would often differ. It reminded me that regardless of how smart and well informed we are, three people can look at the exact same set of circumstances and, based on their own personal experiences and views of the world, come to very different conclusions. That’s what makes economic and market forecasting so difficult. Only time will tell which of these giants of economics will prove the most prophetic.

The general consensus among the group, however, was that the US economy is generally pretty strong, but that uncertainties were rising. From debt levels to rising interest rates and international trade negotiations, there seemed to be consensus that much of the slow down that’s been felt recently comes from policy uncertainty. This uncertainty is accelerating the natural slow down that was expected for 2019. That being said, the only GDP growth number thrown out during the event was 2.5% for 2019, which no one seemed to disagree with. At worst that would represent a modest slowdown compared to 2018.

There were many fascinating topics discussed throughout the event, so I’ll be picking a few of my favorites to go into in more detail in future posts, so stay tuned.

Since 1976, there have been 20 government shut downs. This year alone we’ve already seen 2 of them, both less than a week long. We also had one during the Obama administration that lasted 17 days. Standard & Poor’s estimates that the Obama era shut down cost the US economy about $24 Billion of lost economic activity. Yet, the S&P 500 actually went up by 3.1% during that time. Take a look at this table:

We’ve had shut downs under Democrats, and we’ve had shut downs under Republicans. We’ve had shut downs during good times. We’ve had shut downs during bad times. The one common factor is that they’ve all ended…eventually. The average shut down over this period was 8 days.

Yet, the median return during those 20 shut downs is exactly 0% (mean average is -0.4%). 50% of the time the market goes up, 50% of the time the market goes down during a shut down. At the end of the day, a government shut down may make for great ratings for the media but the reality is that they’re generally a non-event for the stock market. This is yet another example of noise that is driving fear, since we may not even get a shut down in the first place. Fear is what’s been moving markets over the past 3 months, and it’s been in no short supply.

So what’s an investor to do? Keep your eyes down the road on where you want to go, and don’t let the bumps in the road distract you. Remember that properly constructed portfolios are designed to work over time, but there will occasionally be times when it doesn’t feel like it. These strategies need time to work, so the best thing for long term investors to do is avoid mistakes. Not sure what that means? Take a look at this post from a few weeks ago: Driving on Ice.

Going back to our race track example, by over-driving the car you put more stress on the tires, therefore overheating and wearing them out faster. At the same time the driver’s interactions with the various inputs to the car, like the steering wheel and brake/gas pedals, become faster and choppier, which upsets to the balance of the car. Add in the extra stress their brains are under from focusing on going faster rather than the big picture and it becomes easy to understand why their lap times are going up rather than down. Instead, focusing on the fundamental aspects of driving, from the way you handle your steering, brake and gas inputs to the line you’re taking through the corner, is where the most lap time is to be found.

For the traffic example, it’s impossible to properly judge which lane will end up getting you to your destination the fastest because you can’t see far enough down the line of cars to make an accurate prediction. Further complicating things is the fact that you aren’t the only one trying to pick the fastest lane. If you’re seeing an opportunity one lane over, odds are that the other drivers that are looking to get ahead see it too. If enough drivers make the same lane change it will clog up the once promising opportunity, while leaving space in the now vacated lane allowing traffic to start moving there. In many cases you would have been better off staying put.

The same is true when it comes to proper portfolio diversification. Investors often try too hard to outperform the market by jumping out of one asset class and in to the another, often chasing the performance of what’s been recently doing well. Just like traffic, however, it’s impossible to know if that outperformance will persist, or if the underperformers you just left will finally turn around and become the new hot investment. Take a look at the chart below:

This crazy hodge podge of color is called a quilt chart and is put together by our friends at JP Morgan Asset Management. Each colored box represents a different asset class, all of which are then ordered vertically based on calendar year performance for the given year (each column represents a calendar year). The take away here is how complicated the chart is. What was at the top one year can often be found towards the bottom in later years and vice versa. Therefore, picking the best and avoiding the worst is very challenging, if not impossible, just like choosing the right lane.

In most cases, you’re better off owning all of them to some degree, with the amount of each based on your applicable time horizon and risk profile. Think of this diversified, risk based strategy as your driving fundamentals, which you should first focus on perfecting to go faster. Once the baseline strategy is optimized, making small tactical shifts between asset classes, like the driver that is adapting their driving style to changing road or traffic conditions, can add value so long as a data driven analysis is driving the shifts. Without that defined process, shifts that are meant to get you out of a traffic jam could end up leading you into a crash.

To explain what I mean, let’s start with a review of what’s actually happening when your car refuses to turn and continues going straight despite a turned steering wheel. For those of us living in the Northern Mid-West, it’s a common occurrence in winter when roads get icy. On the racetrack, it’s even more common and can be caused by weather affecting the available grip, or just going too fast. Regardless of where it’s being experienced, it’s a phenomenon known as understeer.

So what’s happening here? Your tires only have 100% of their capability to give at any time towards any actions, based on the available friction given road, car and tire conditions. You can be using 100% for maximum braking, or 100% for maximum acceleration. You can use 50% for braking and 50% for turning. You can do any combination you’d like so long as you don’t go over 100%. As soon as you ask the car to go over the 100% threshold, physics won’t allow the car to respond as you’ve asked.

In the case of understeer, the driver is asking for more than 100% of the tires’ current capability to make the turn. The effect is a plowing of the front wheels where, despite a proper turn of the wheel that would normally have worked, the car continues moving straight. The tires have given up because you’ve asked too much of them.

So what does this lesson on vehicle dynamics have to do with financial markets? The answer is in the way people instinctively react to understeer. An untrained driver will almost always try to correct for understeer by turning their steering wheel more. Instinctually, it makes sense. You want the car to turn left, but it’s going straight. Therefore, turn more to the left and the car should follow. However, what did we just learn about the physics of what’s happening? The car is telling us that it can’t turn to the left the way the driver wants because it would require more than 100% of the available tire grip. Asking for more turn means asking for more grip from tires that are already beyond maxed out. Instead, the correct action is to let the tires gently scrub off speed (get off the gas, don’t jump on the brakes) and unwind the steering wheel until the tires get back to below 100% and start to grip. After the car is back under control you’ll be able to make the turn. Ask less to do more. It’s very counter intuitive.

Investors face a similar dilemma during periods of market turmoil, which can be just as scary as sliding on ice. As my colleague Eric Laumann, CFA wrote in his recent blog post “The Year Nothing Worked”, 2018 has provided plenty of these driving on ice type situations for investors. Just like the untrained driver, untrained investors tend to have the wrong initial reaction to sliding markets. In an effort to protect their portfolios, many investors sell in to market weakness with the justification that at least the values won’t go any lower. Doing so, however, only realizes the lost value of the securities in your portfolio. This investing understeer leaves you out of the market for the eventual rebound in prices. It’s incredibly difficult, if not impossible to routinely time markets like that. Instead, build a strategy that is appropriate for your risk profile and ride through tough periods, thereby giving your strategy time to work and using those periods of volatility to your benefit by buying when securities are on sale rather than selling. This is one way a professional advisor can add value, by keeping you from making the wrong instinctive correction. Let your advisor be your traction control when things get icy.

Altruistic givers are motivated by an unselfish concern for the benefit of others. It’s the output of the charity, and its positive effect on those in need, that moves them to donate. Warm-glow givers, on the other hand, give because it makes them feel good about themselves. Regardless of which type of motivation might drive the giver, charitable giving comes from the heart and helps improve the lives of our friends and neighbors in need. While that’s the most important aspect of giving, there is also a third motivation that helps spur generosity: the charitable contribution tax deduction.

Under the tax code you’re allowed to deduct up to 60% of your Adjusted Gross Income (AGI) if those gifts are made in cash and up to 30% of your AGI if you gift other assets (appreciated stocks, real estate, tangible goods, etc.). Gifts over these amounts are allowed to be carried forward for up to 5 years to be used as future deductions. The catch, however, is that in order to take advantage of the charitable gift you made you first have to be itemizing your deductions on your tax return. That means that when you add up all of your individual tax deductions (state and local taxes, mortgage interest, charitable gifting, qualifying medical expenses, etc.) the sum must be larger than the standard deduction, since the higher of the two is what’s used. Under the new Tax Cuts and Jobs Act the standard deduction has been nearly doubled to $12,000 for single filers, $24,000 for married couples filing jointly. In fact, the IRS estimates that only about 5% of taxpayers will itemize in 2018, compared to about 30% in prior years. In other words, the bar to itemize, and therefore get a benefit on your tax return after a charitable gift, has gotten higher while at the same time limits and reductions to those types of expenses that are itemizable deductions have made it even harder to meet that threshold. There are, however, gifting strategies that can give a tax benefit to even if you don’t itemize.

1. Qualified Charitable Distributions

For those over the age of 70.5 years with traditional IRA balances, the tax code allows each person to direct up to $100,000 of their annual Required Minimum Distribution to a qualifying charity without having to add the amount to your taxable income for that year. That means that you don’t have to itemize your deductions to get credit for the donation, since the donated amount has already been excluded from your taxable income rather than being treated as an itemizable deduction. You’re also allowed to do partial gifts, in case you still need a portion of your required minimum distribution for living expenses or if you want to donate to multiple charities. The distribution check must be made payable to the charity, though it can be sent to the donor and passed on to the charity. Following that path ensures that you can get a receipt for your donation, which is important to keep with your tax records. You cannot, however, have the distribution paid to you and then turn around and gift it to the charity. In that scenario you would be back to having to use the itemized deduction to get the tax benefit. In order to be a qualifying charity the organization must be a 501(c)(3). Private Foundations and Donor-Advised Funds, unfortunately, are not eligible recipients.

2. Gifting Appreciated Securities

For many investors, rising markets over the years have led given them investments that are worth far more than they originally purchased them for. Be it stocks, bonds, mutual funds, ETFs or any other financial security that is held in a taxable investment account (i.e. not IRAs or 401(k)s), the difference between the higher current market value and the original purchase cost is called a capital gain and is taxable upon the sale of the security at rates determined by how long you’ve owned the security for. Herein lies another gifting opportunity. Rather than giving cash to your favorite charity(ies), instead consider gifting shares of these highly appreciated securities of an equivalent value. While this strategy doesn’t get you around the requirement to itemize your deductions to get a current tax year benefit, it does allow you to avoid paying the extra tax on the capital gain that you would have been liable for upon the liquidation of the security. Since qualified charities are tax exempt, they don’t have to pay any taxes on the gains when they liquidate the shares you’ve donated to fund operating expenses. Remember, though, that in order to qualify for this strategy the security(ies) you are donating must have been held in your account for more than a year. The value of the security(ies) you plan to donate must also be higher than their original purchase cost. If the positon has lost value over time then you’re better off selling the position yourself and donating the cash proceeds. Finally, remember that you can only deduct the value of donated securities up to 30% of your AGI in a given year.

3. Bunch Future Gifts into a Single Tax Year

One option to help you qualify for the itemized deduction is making less frequent but larger donations that are more likely to get you over the standard deduction hurdle. In other words, rather than giving $5,000 per year you could make a $15,000 donation every three years. You could gift directly to the charity(ies) of your choice as a lump sum, or you could use a Donor Advised Fund or Private Foundation to spread the donation out over time. Remember, however, that the donations made are still subject to the annual AGI limits for deductibility (60% for cash, 30% for appreciated assets). You are allowed the five year carry forward, however that only helps you if you itemize in future years. If you’re likely to revert back to the standard deduction in the years following your bunched contribution then the carry forward likely won’t help, so be sure to discuss that option with your tax advisor.

Giving is done best when it’s done for the right reasons. Find a cause and an organization that you’re passionate about, and then engage your professional advisor team to ensure that you structure your gift so that the organization and your family gets the maximum benefit. The tax code was designed to incentivize charitable giving, so don’t be bashful about taking them up on the offer!

A beneficiary designation is a simple form that lists who gets what percentage of the assets in a specific account in the event of your passing away. They are used in IRAs of all types (Roth, Traditional, Rollover, SEP, SIMPLE, Inherited/Beneficiary), employer sponsored retirement plans (401(k), 403(b), 457, pensions, etc), and insurance contracts (life insurance and annuities). You can also add a beneficiary designation on taxable accounts, such as individual or Joint Tenancy with Right of Survivorship, through a Transfer on Death (TOD) designation (sometimes call Payable on Death, of POD). Remember that each account you have must have its own beneficiary designation form specific to just that account. As an example, if you have two IRAs, you will have two beneficiary designation forms. They don’t have to all be the same, but be sure this is done on purpose and not because you forgot to update them.

There are two main reasons to use the beneficiary designation; clear and concise instructions for how you want your assets to be distributed to your heirs, and the avoidance of probate. These forms make it clear how you want to structure your inheritance, potentially reducing the risk of contested estates, and makes it easy for your heirs to claim their funds. Typically, they simply need to provide personal identification along with a copy of a death certificate to begin the process of claiming their share. Even more importantly, it allows your heirs to avoid going through the probate court system to claim their portions. Remember that probate is the process where your local court system distributes assets based on your will, or by a statutory hierarchy determined by your state’s intestacy laws when no will exists.

It’s generally considered a good idea to avoid probate where possible since it can be a long process, months or even years depending on the state and the complexity, during which assets can be tied up and unavailable to support surviving loved ones or pay bills. Naturally, anything that takes time in court can also get quite expensive. Finally, everything done via the probate court is public information, which means details of your probate estate are out there for anyone to see. All of this can be avoided by keeping an up to date beneficiary designation on file for the account types that permit it.

There are two types of beneficiaries that you will be asked to name on a beneficiary form; Primary and Contingent. You can think of them as two teams, your A team and your B team. Your A team, the primary beneficiaries, is the person, or persons, that you’d like to receive some portion of the money. If none of your primary beneficiaries survive you, or are willing to accept their portion, then your B team will step up and take the place of the primary beneficiaries. As such, the allocation amongst members of each team needs to equal 100% (primary beneficiaries must equal 100%, contingent beneficiaries must equal 100%).

You also have options for how to handle situations where a portion of your beneficiaries, primary or contingent, are not able to claim their portion of their inheritance. The most common, and often default, option is to redistribute their share amongst the remaining beneficiaries in that class pro-rata, also known as per capita. As an example, say you name your two children as primary beneficiaries each with a 50% share. If one child predeceases you and you’ve selected a pro-rata option, their share will go to the remaining child. Only if both children are unable, or unwilling, to claim their share will the contingent beneficiaries step in. The second option for situations like this is called a per stirpes designation. Per stirpes is Latin for “by the roots”, and allows for a beneficiary’s share to pass to their descendants if they aren’t available to claim it themselves. Going back to our previous example, if you had instead opted for a per stirpes election then the 50% share that was intended for your deceased child would go to their heirs in equal shares. The other child, and original beneficiary, would still receive their 50%. In this situation, only if both primary beneficiaries had predeceased you with no living heirs would the contingent beneficiary(s) step in.

You are permitted to name anyone as a beneficiary on your account in any amount. However, be aware that there are special rules for people that are married. When dealing with employer sponsored retirement plans, like a 401(k), there is a federal law, called ERISA, that gives your spouse a right to be 100% primary beneficiary. You are allowed to name someone instead of, or in addition to, your spouse, however they must sign off on the election form waiving their right to be the sole primary beneficiary. This is often also required to be done in front of a notary. If you don’t have your spouse sign off on the form then they will have the right to supersede your beneficiary election and claim it as their own.

Non-ERISA accounts, like IRAs and insurance contracts, are not subject to the federal spousal beneficiary rule. Rather, they are handled at the state level. Most states don’t require a spousal waiver, however certain states, especially community property states like Wisconsin, may. It’s important to discuss this with a qualified estate planning attorney to understand your state’s requirements. When in doubt, it won’t hurt to have your spouse sign off on the designation form if you want to be certain those other beneficiaries get their share.

One common concern for people is what would happen if a minor child that was named as beneficiary would inherit a large sum of money. In those cases, the appointed guardian of the minor child would be tasked with managing that money until the child reached the age of majority. They’d be required, as fiduciaries, to act in the best interest of the child and only to spend those dollars on the child.

What happens if none of your beneficiaries survive you? In that case it depends on the type of account. For most ERISA employer sponsored retirement plans, like 401(k)s, there will be a built in beneficiary hierarchy in the plan document. If there isn’t, or none of their prescribed beneficiaries exist, then the account will be sent to the probate court to be distributed per your will. This is a highly inefficient way to pass a tax preferenced retirement account, as the beneficiaries lose the ability to continue the tax preference, often referred to as the stretch benefit. You also then have to deal with the short comings of the probate court discussed above.

In summary, beneficiary designations are powerful contracts that should be considered carefully and routinely reviewed and amended as life events unfold. Having an accurate beneficiary designation takes minutes to accomplish, and is the best gift you can leave to your heirs. Don’t force them to give up tax benefits, lose some or all of their inheritance, or potentially have to fight each other at a time when they’re already under stress from your passing. This is a big decision, but remember that your financial advisor, in coordination with your estate planning attorney, can be a helpful resource to ensure your desires are being properly expressed. Please feel free to contact us with any questions you might have.

The basic premise is fairly straight forward: use your retirement funds to invest in physical real estate and enjoy tax advantaged growth and income generated by the property. For many investors, their IRA balances represent a large source of liquidity, which can be used to fund the transaction rather than having to finance the project or support it out of cash flow or other savings. While this strategy may seem attractive on the surface, the reality is that while the strategy can work under the right circumstances, the strict rules surrounding IRAs makes them a tricky, if not outright poor, shelter for this type of activity.

First, let’s discuss the specifics of how this strategy typically gets implemented. There are several IRA custodians around the country that specialize in “Self-Directed” IRAs, which will work with investors that want to hold alternative assets in their IRA, such as real estate or physical gold bullion. You may also use a Roth IRA, should you wish. It’s important to note that while it’s legal to hold these types of assets in an IRA, the only prohibited investments are life insurance, collectibles/antiques and some types of derivative contracts, the majority of custodians do not permit physical holdings inside IRAs because they don’t have the infrastructure needed to properly handle those types of assets. Therefore, in order to purchase a piece of real estate, investors would first need to open an IRA at a custodian designed to handle it and then roll funds into it. Bear in mind, the custodian will only be handling the custodian duties, and will not provide any advice or help beyond that, hence the term “Self-Directed”.

Once the IRA has been established and funded the next step is to purchase the property. This is where things start getting tricky. The IRA, which can be thought of as its own entity that exists for your benefit, will be who actually buys the property, and who’s name is on the title. It’s important to note that all of your funds being used in the purchase have to come from the IRA. You cannot personally pay for anything. More on this to come later. It is possible to finance the purchase, so long as it’s a non-recourse loan, or to take on partners but it’s important that tax attorneys are involved to be sure the deals are structured properly. A loan will also lead to an unrelated business income tax (UBIT), which applies despite the tax preferences usually associated with IRAs.

There are also restrictions on what properties you can buy with an IRA. The first restriction is against self-dealing, which means you can’t purchase a property that is owned by you or any disqualified person. A disqualified person would include you and your linear relatives (think grandparents through grandchildren) or their spouses, any entity you own at least 50% of, or any fiduciary such as your investment advisor. You also cannot enjoy any indirect benefits from the property. That means you can’t purchase a vacation home with the intent to rent it out most of the year, but to use it occasionally for yourself or any of the above listed disqualified persons. You are also prohibited from using the property as collateral for a personal loan, as the property belongs to the IRA.

Once the property has been selected and purchased no disqualified person can actively provide any services for the property. That means neither you nor any other disqualified person can work on the rehabilitation of the property, which removes the ability to gain “sweat equity”. If you are planning to rent the property out you can’t even act as the land lord, or actively participate in finding a tenant. Instead, you must hire an unrelated management company. Furthermore, all expenses of maintaining and/or improving the property must be paid for by the IRA, through the custodian. You can’t pay for anything out of non-IRA assets. Similarly, all income generated, such as rents, must flow through the custodian directly back to the IRA.

So what happens if you violate any of these restrictions? Generally, the assets in the IRA involved in the violation are treated as if they’d been distributed, and are included in that year’s taxable income to the traditional IRA owner. In other words, the IRA stops being an IRA. The taxation of Roth IRAs in this situation are a bit more complicated, and depend on the amount of time the Roth has existed. If the owner is under 59.5 years old there could also be a 10% early distribution penalty. Furthermore, the tax preferences granted to IRAs, either tax deferred growth for a traditional IRA or tax free growth for a Roth IRA, will be forfeited going forward. As you can see, it’s a stiff penalty for a violation that can easily be tripped accidentally if you aren’t well versed in the tax code.

Speaking of the tax code, there are some other draw backs to this strategy that should be discussed. Investors that choose to purchase investment properties in their IRA will give up many tax deductions commonly associated with real estate, such as depreciation and interest deductions. They will also lose out on the opportunity to pay taxes on future gains, when the property is sold, at the lower long term capital gains rate, as all distributions from traditional IRAs are taxed as ordinary income. Roth IRA distributions on the other hand, are typically tax free if you follow the distribution rules.

Another aspect of traditional IRA investing that becomes more complicated when purchasing investment properties relates to the Required Minimum Distributions (RMD) that are required to start once you’ve turn 70.5 years old. In order to determine how much you need to take out of the account, and therefore pay income taxes on, you need to know what the value of the assets in the IRA was at the end of the prior year. That means annual property appraisals will be required. It also means that there has to be enough liquid assets in the IRA to distribute each year, such as cash or other securities or else you’ll be required to distribute portions of ownership of the property. That will quickly become cumbersome from an accounting perspective. Fortunately, Roth IRAs don’t require RMDs, which removes some administrative burdens, however your heirs will be required to take RMDs out of your Roth after your passing.

To summarize, while it is legal to own illiquid assets, such as real estate, in your IRA it is not a strategy that should be taken lightly. The many restrictions and administrative costs can quickly offset any potential tax savings, especially when you consider the loss of common tax deductions. Bear in mind also that you can gain exposure to the real estate market in your IRA through the use of publicly traded Real Estate Investment Trusts (REITs), which contain a diversified portfolio of properties, without the restrictions or costs of the physical asset. In either case, you should be sure to have a trusted team of advisors, such as a financial advisor, attorney and accountant, to help you make the best decision for your situation prior to making any investments.

What types of accounts are subject to Required Minimum Distributions?

The majority of retirement accounts are subject to RMDs. This includes Traditional IRAs, Rollover IRAs, SIMPLE IRAs, SEP IRAs, Inherited Traditional IRAs, Inherited Roth IRAs, 401(k)s, 403(b)s, and 457(b) plans. The only tax preferenced retirement accounts that aren’t subject to RMDs are Roth IRAs. This is one of the reasons they’re so popular for savers looking to maximize the legacy they leave for the next generation. To make things more complex however, the Roth balance of a 401(k) is subject to RMDs, so be sure to understand what types of accounts you have.

How are Required Minimum Distributions calculated?

RMDs are calculated annually by taking the year-end balance of the prior year and dividing it by the saver’s remaining life expectancy taken from tables provided by the IRS and based on the age of the beneficiary at the end of that tax year. There are several different life expectancy tables depending on the type of beneficiary the saver has named. The Joint and Last Survivor table is used when your spouse is your primary beneficiary and they are more than 10 years younger than you. The Uniform Life table is used when if your spouse is not the sole beneficiary, or if your spouse is less than 10 years younger than you. Finally, the Single Life Expectancy table is used for the beneficiaries of inherited accounts. Since each retirement account has its own beneficiary designation, it’s important to remember to do this calculation for each account. It’s also important to remember that you can always take more than the required amount, but you can’t count the excess amount against any distributions required for future years.

When do Required Minimum Distributions begin, and when must they be taken by?

Generally, your first RMD on your own retirement accounts must be taken for the tax year in which you turn 70.5 years old. You must take that first RMD by April 1st of the year after you’ve turned 70.5. From then on you must complete each year’s RMD requirement by December 31st. While you are allowed to push that first RMD into the following tax year you will also have to take that year’s own RMD by year end. Since the taxable income from an RMD is counted in the tax year the distribution is taken, you would be taxed on two distributions in the same year which could push you into a higher tax bracket. Your accountant can help you determine whether or not to delay your first RMD .

If you are still working at age 70.5, you may not be required to take an RMD out of your employer sponsored retirement plan, like a 401(k). Many plans allow you to delay your RMD start date until the year you retire from active employment. This delay only applies to the balance in your current employer’s plan, not for IRAs or 401(k)s from previous employers. This exception also does not apply to anyone that owns 5% or more of the company they work for and does not apply to SIMPLE or SEP IRAs.

Can I use my Required Minimum Distribution to make an IRA contribution, or roll it into a different IRA?

In most cases the answer is no. You can only continue contributing after age 70.5 to certain types of accounts, assuming you still have earned income. You are permitted to make contributions after 70 in Roth IRAs, SIMPLE and SEP IRAs, and 401(k)s provided you’re still working for the plan sponsor and their plan allows for the delay of your RMDs. Since SIMPLE and SEP IRAs do not qualify for delaying RMDs, this means that you would both be contributing to the account and taking distributions out of it in the same year.

Do distributions have to come from each account?

The answer to this question is dependent on the type of accounts being considered. For IRAs (including Traditional, Rollover, SIMPLE and SEP IRAs) and 403(B) plans, while you must calculate each account’s RMD separately you are permitted to aggregate them for the actual distribution. This means you can take the RMD for all of your IRAs out of only one of them, or you can take them out of each account. The IRS doesn’t care which IRA the distribution(s) come from, so long as the required minimum amount is taken out and, therefore, taxable.

401(k) plans and inherited IRAs (both traditional and Roth), however, require that each account’s RMD be taken from that specific account’s balance. You are not allowed to aggregate the balances across these types of accounts for distribution purposes.

How do inherited accounts work?

If you’ve inherited a tax qualified account you will typically be required to start taking RMDs. The only exception to this rule is if the account is inherited from your spouse. In that case, you are permitted, but not required, to treat the inherited account as your own. You can roll the balance into one of your own existing qualified accounts (IRA, 401(K), etc) rather than into an inherited account. RMD rules would then apply as normal. If you’ve inherited the account from a non-spouse then you’ll be required to start taking RMDs. You have however some flexibility on how and when you take them depending on whether the now deceased original owner had passed age 70.5 and was required to take RMDs themselves. Of course the first universal option is to take an immediate lump sum payout. Doing this means you are giving up any potential tax preferenced growth on the account balance, and will incur a potentially large income tax liability (assuming the funds aren’t Roth after tax dollars). These issues can be avoided by using one of the following options.

If the original owner passed away after age 70.5 you are required to start taking RMDs based on either your life expectancy or the deceased. If they were younger than you, by December 31st of the year after the original owner passed away. However, the IRS also requires that the RMD for the year of death of the original owner be processed as if they lived through the entire year. This means that if they hadn’t already taken their RMD prior to passing away, you must process the distribution before the end of that year.

If the original owner passed away before turning 70.5 years old then you can either take annual distributions based on your life expectancy, like above, or you can use a 5 year lump sum method. This option allows you leave the entire balance in the inherited account for up to 5 years, growing tax deferred. However, the full account balance must be distributed by December 31st of the 5th year. This 5 year rule can also be applied to an inherited Roth account regardless of the age of original owner upon their passing

What if I miss a distribution?

As mentioned earlier, missing an RMD can be an expensive error. The IRS penalty is 50% of the missed distribution. That applies whether you miss the entire amount or just part of it and is in addition to your normal required taxes. The good news is that the IRS does give you a way to avoid this penalty, provided the failure to withdraw the full and correct amount was due to a reasonable error, and that steps are being taken to correct the mistake. This means you would need to get the proper amount distributed and then file a form 5329 with a letter of explanation. Your accountant should be able to help you with that.

In conclusion, always remember that these rules, while complicated, can be easily followed with the help of your professional financial services team; your financial advisor and accountant. Most custodians of tax qualified accounts will also communicate with you when it’s time to start taking RMDs, and most even have a system that will automatically calculate and distribute the required amount each year. Be sure to speak with your advisor if you aren’t currently enrolled in such a program.

Simply put, MLPs are Limited Partnerships that can be publicly traded on exchanges like a stock. A big advantage to this business structure is that they don’t pay income tax at the entity level; rather that tax is passed through to the investors based on their ownership portion. In order to qualify as an MLP the business must earn at least 90% of its income from “Qualified Sources” which are namely activities relating to natural resources or real estate. The most common examples of MLPs are businesses that build and operate energy infrastructure, such as oil and natural gas pipelines, storage facilities and refineries. The business must also distribute all income in excess of operating costs to its owners, which is what creates the strong cash flow that many investors find appealing, particularly given the low interest rates available in the bond market. This income also creates a complex tax situation that few investors are aware of.

Just as income will be passed on to investors so too will liabilities and expenses, including partnership expenses and depreciation, which investors can use to offset some of the income generated on their taxes. That means that often as much as 80-90% of the quarterly income distributions from direct ownership of an MLP will be treated as a return of capital, meaning that investors don't have to pay income taxes right away on that money. Instead, that portion of the distribution simply lowers the owner’s cost basis in the product. Remember that cost basis is what you paid to buy the product, and that capital gain taxes are paid only on the value above what you paid on an investment upon its sale. Therefore, when dealing with a taxable account, you are effectively putting off the tax bill on the income you are getting from the product until you sell the MLP.

Once your cost basis reaches $0, then most of the income that was treated as Return of Capital and any price appreciation would be taxed as Long Term Capital Gain, while certain amounts that were written off for things like depreciation would be recaptured and taxed as Ordinary Income. The details of each year’s distributions will be reported to owners via a form K-1, which can make tax time a bit more complicated as the details of each distribution will need to be tracked for proper tax reporting down the road. Be sure to consult your tax advisor when considering the use of individual MLPs in your portfolio.

Many people seek to simplify the tax situation by holding individual MLPs inside a tax qualified account, such as an IRA or a Roth IRA. While there’s no regulation that prohibits this, it may not be a wise idea. First, you’re adding a tax advantaged asset into an already tax advantaged account, therefore wasting a tax benefit by taking the spot of other assets that could have benefited if they had been held in the IRA with those funds being used to buy the MLP. Even more importantly, holding an individual MLP in an IRA may trigger an unexpected tax bill from Unrelated Business Taxable Income (UBTI). (I.R.C. §§511-514)

UBTI results when a non-taxed entity, such as an IRA, 401(k), or 501(c)(3) charity, generates revenue through a business line that is unrelated to their exempted purpose. As an example, imagine a school that operated a business selling widgets for a profit. Selling widgets has nothing to do with education,

so the profits would be taxable to an otherwise tax preferenced entity. When your IRA invests in an MLP it becomes a limited partner in that business and, since MLPs are a pass through entity, your IRA is effectively earning a share of the business income. The tax code considers that income to be unrelated to the retirement account’s purpose, saving for retirement, and therefore becomes taxable. The actual amount of UBTI would be reported on the annual K-1 document. Thankfully, the first $1,000 of aggregate UBTI in the IRA is exempt from taxation, and not all MLPs spin off UBTI each year, but anything beyond that will be taxable.

Technically, it will be the IRA that owes taxes once the aggregate level of UBTI exceeds $1,000, not the IRA owner. Therefore, you won’t pay the taxes as part of your normal 1040 filing, but rather the IRA will pay the taxes out of IRA assets by submitting a form 990-T to the IRA’s custodian. The custodian will actually file and pay the taxes for the IRA. What’s more, IRA tax brackets work off the same marginal rates as trusts, which are far more condensed than the personal rates and are listed in the table below:

As you can see, it doesn’t take much before the IRA gets to the top tax bracket. Fortunately, the IRS grants investors some relief in that there won’t be a 10% early distribution penalty on the taxes paid out of the IRA if the owner is under age 59.5, as it isn’t the owner’s distribution.

Despite all of the complexities, the MLP space can be an attractive addition to a well-diversified portfolio for the reasons already discussed. So how does one get exposure to this asset class in their qualified accounts without triggering this little known area of the tax code? Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs) and Open and Closed End Mutual Funds can give investors exposure to diversified portfolios of MLPs, rather than individual MLPs, without having to worry about generating UBTI or, in some cases, even having to deal with a K-1. These are also complex securities and involve their own risks and tax structures which should be discussed with both your Financial Advisor and your Tax Advisor prior to use, but are certainly an option for those looking to pick up exposure.